First published by Global Legal Group, January 2021.
The subscription credit and fund finance markets have remained relatively robust over the course of 2020, though the COVID-19 pandemic has presented certain challenges for market participants. Growth in this area over the past few years was driven in part by expansion of the product into a broader range of fund types, increasing take-up by fund sponsors who had not traditionally used the product in their fund families, record levels of fundraising and an increasing number of net asset value (NAV) facility closings.
While certain banks have continued to increase their book of business and new Lenders have emerged on the scene, others have taken a step back for the time being. Given that strong credit performance remains the norm in this market, the relatively low-risk profile of the product will continue to make it attractive for Lenders.
The Cayman Islands continues to be a pre-eminent offshore jurisdiction for the establishment of private equity funds, particularly for North American fund managers and Asia-focused funds, and has recently been named "Best Private Equity Fund Domicile" by industry publication Private Equity Wire. The exempted limited partnership (ELP) also continues to be the private equity fund vehicle of choice. According to figures published by the Cayman Islands Registry of Exempted Limited Partnerships, as at the end of 2019, the number of active ELPs in the jurisdiction had risen to 28,469 from 26,011 at the end of 2018. 2,458 ELPs were registered in the Cayman Islands in 2019, and 2,878 ELPs have been registered in the Cayman Islands as at August 2020. In fact, March 2020 saw the highest number of partnerships registered in a single month since the inception of the register of partnerships.
No doubt buoyed by the familiarity of US counsel and fund managers with Delaware limited liability companies (LLCs), the use of the Cayman LLC as a business vehicle has generally been on the rise since its introduction in July 2016, though figures through to August this year reflect the lower levels of activity experienced during the early months of the COVID-19 lockdown. According to figures published by the Cayman Islands Companies Registry, there were 3,265 Cayman LLCs registered in the Cayman Islands as at August 2020.
The success of the Cayman LLC can, at least in part, be attributed to the decision by legislators, in collaboration with the private sector, to introduce a vehicle that is similar to the Delaware LLC. Familiarity with this type of vehicle facilitates usage and offers the benefit of operational consistencies across the onshore and offshore segments of fund structures. Cayman LLCs are most commonly used as joint venture vehicles, carried interest vehicles, downstream blockers, and investment management vehicles. The authors are also aware that a handful of Cayman LLCs has been used as investor-facing fund vehicles, including by Asia-based fund managers.
Successful public and private sector discussion and collaboration are but two of the factors contributing to Cayman's market-leading position in this space. Others include: (i) historical familiarity with the jurisdiction by investors and fund sponsors; (ii) the increasing convergence of hedge fund and private equity sectors, as more fund managers offer and operate both products from the same platform; and (iii) Cayman law's English common law roots, supplemented, as necessary, by local legislation, which ensures that Cayman Islands funds are recognised as internationally accepted vehicles.
Globally, Preqin's Q3 2020 Fundraising report reflects somewhat of an interruption in fundraising levels with only 237 funds closing in Q3, representing an 18.3% decrease on Q2. Yet, the report reflects a global growth in average fund size to USD 536 million, which reflects a continuation of the trend whereby the more established general partners account for the largest proportion of aggregate capital raised by funds closed.
Funds raised in North America accounted for 60% of the global total by number, and raised an aggregate USD 51 billion in capital commitments. While North America-focused funds have continued to dominate fundraising, the figures published by Preqin indicate, however, that Europe-focused funds raised more capital in Q3 through fewer but larger funds, reflective of capital consolidation in the space. This continued geographical emphasis on the North American market corresponds with activity in the fund finance space, where the Appleby Cayman office continues to see a steady progression of instructions in the subscription credit facility market from referrers in North America, involving traditional players and new entrants to the market. Indeed, the Appleby Cayman office continues to be a market leader in this area, where it continues to represent the largest global banks on a variety of financing structures.
Fund formation and finance
Lending to Cayman Islands funds
Cayman Islands private equity funds have historically been registered as ELPs under the Exempted Limited Partnership Law, as amended (ELP Law). The Cayman LLC, registered under the Limited Liability Companies Law, as amended (LLC Law), is a hybrid form of business vehicle, merging certain characteristics of a Cayman n Islands exempted company and an ELP.
Though registered pursuant to the ELP Law, an ELP is not a separate legal entity. Rather, an ELP reflects a contractual agreement between the partners, where the general partner is vested with certain duties and powers with respect to the business and its assets. Any rights and obligations of the general partner and the limited partners are therefore contractual in nature and will be governed by the provisions of the limited partnership agreement and any subscription agreements (and/or side letters) signed by the limited partners. The ELP's rights and property of every description, including all choses in action and any right to make capital calls and to receive the proceeds thereof, are held by the general partner in trust as an asset of the ELP. A Cayman LLC, on the other hand, is a body corporate with separate legal personality and limited liability. It can therefore hold such property and assets and incur obligations and liabilities in its own name.
The legal treatment of an ELP and the corresponding role of the general partner have a number of implications for Lenders offering subscription credit facilities to Cayman Islands vehicles when structuring the related security package. Limited partners of an ELP will usually commit in the partnership agreement and/or subscription agreement to fund investments or to repay fund expenses when called upon to do so by the general partner from time to time. This contractual obligation of a limited partner to fund its capital, to the extent that it has not already been called (Uncalled Capital), and the corresponding right of the ELP to call for Uncalled Capital (Capital Call Rights), are the backbone of the subscription credit facility. Given that these rights, or choses in action, are contractual in nature, the appropriate form of security over such rights is an assignment by way of security. As discussed above, legal title to such assets ultimately vests in the general partner of the ELP and, being contractual in nature, such rights are exercisable by the general partner for the benefit of the ELP.
Consequently, the proper parties to any grant of security are the general partner as well as the ELP (acting through the general partner), as the ultimate beneficiary of such assets. Where the obligor in a subscription-secured credit facility is a Cayman LLC, however, legal title to Uncalled Capital and to Capital Call Rights should vest in the Cayman LLC itself, with the manager having such power and authority as set out in the LLC Agreement to make calls for Uncalled Capital and to receive capital contributions from the members in accordance with the terms of their subscription agreements .
Accordingly, where a Cayman LLC is the obligor, the security package could be simplified in that only one entity – the manager on behalf of the Cayman LLC – need be a party to the relevant security agreements. The LLC Law allows considerable flexibility in the structuring, governance and administration of the Cayman LLC, as it defers in many instances to the LLC Agreement. Members of a Cayman LLC will therefore have relative freedom to introduce features typically associated with ELPs such as capital accounts, capital commitments and capital calls, provided that the provisions of the LLC Agreement do not contravene the LLC Law or any other laws of the Cayman Islands. Each member of the Cayman LLC will also typically enter into a subscription agreement, setting out the terms on which it agrees to be a member, and to fund its capital commitment to the Cayman LLC.
In all instances, the optimal security package would incorporate an express irrevocable power of attorney in favour of the Lender to exercise effectively the general partner's or the Cay man LLC's Capital Call Rights following the occurrence of an event of default.
In addition, the security package will typically include the grant of a security interest over a designated bank account under the control of the Lender. Although the security over Capital Call Rights can be granted under a Cayman law document, it is increasingly common for such security to be granted under a New York or English law-governed security agreement. Assuming that the grant of security is permitted under the Cayman law-governed limited partnership agreement or the LLC Agreement, Cayman courts would recognise the grant of security even if such security were granted under a foreign law-governed security agreement. However, in such a situation, the Lender will need to ensure that the local law opinion covers not only the assignability of the Capital Call Rights, as a matter of Cayman law, but also the recognition of the security assignment, the choice of foreign law to govern the same, and the steps taken to establish priority as a matter of Cayman law.
The terms of the limited partnership agreement or the LLC Agreement play an integral role in the structuring of the collateral package and must be reviewed in detail in order to ensure a number of key elements are present, including but not limited to: (i) the ability of the ELP or the Cayman LLC to incur indebtedness and enter into the transaction; ( ii) the ability to grant security over (x) the Uncalled Capital, (y) the right to make and enforce capital calls, and (z) the related contributions; (iii) the ability to apply the capital contributions toward s the secured obligations; and (iv) acknowledgment by the limited partners or the members of the Cayman LLC of the security assignment and their obligation to fund their capital commitments.
Perfection of security
With the exception of land located in the Cayman Islands, vessels flagged in the Cayman Islands, Cayman Islands-registered aircraft and interests of limited partners in an ELP, generally no perfection steps are required in Cayman and, further, there is no general register of security interests in the Cayman Islands accessible to the public.
Perfection over the Capital Call Rights is achieved through the delivery of written notice of the grant of security (Notice) to the ELP's Limited partners or the members of the Cayman LLC. According to conflicts-of-laws principles, the priority of two competing security interests in a chose in action is determined by the law governing that chose in action. Where a security interest is granted over Capital Call Rights set forth in a Cayman law-governed limited partnership agreement or LLC Agreement, priority of the security interest as against any competing security interest will therefore be determined in accordance with Cayman Islands law. As a matter of Cayman Islands law, where successive assignments of a chose in action are concerned, priority as between creditors is determined based on the English court decision in Dearle v Hall (1828) 3 Russ 1, according to the order in which written Notice is given to a third-party obligor (i.e. the limited partners or the members of a Cayman LLC). Priority is not established in accordance with the time of creation of the relevant security interests. A delay in the delivery of the Notice will therefore open up the Lender to the possibility that the Cayman LLC, or a general partner on behalf of the ELP, may (quite unintentionally) grant a competing security interest or an absolute assignment over Capital Call Rights to a subsequent assignee. Provided that Notice of the second assignment is given to the limited partners or to the members of the Cayman LLC ahead of Notice of the first assignment, the subsequent assignee will rank for repayment ahead of the first assignee.
Equity holders in Cayman Islands vehicles are increasingly aware of subscription facilities. Indeed, sponsors and Lenders alike agree that investors should expect transparency insofar as the use of subscription lines by fund managers is concerned. Familiarity with the product means that there is now much less resistance by such vehicles to giving Notice to their equity holders. In addition, a general "tightening up" by Lenders of certain aspects of their facilities has led to less flexibility around timing for delivery of Notices, with these typically being circulated to the equity holders either immediately upon execution of the security documents, in order to ensure priority is achieved at closing of the subscription credit facility, or within three to five business days of closing, depending on the commercial agreement between the parties.
Given the importance of actual delivery of the Notice to equity holders, evidence of the Notice having been received also assumes so me importance. With advances in the technology of delivery of Notices and reports to investors, such as posting to secure web portals and other similar platforms, the discussion of the appropriate evidence of delivery of such Notices becomes crucial, and is best discussed in the early stages of negotiation of the facility to avoid inefficiencies on closing. If partnership agreements or LLC Agreements are drafted to take into account the technology of how Notices are actually delivered to equity holders, this may prove helpful to the discussion.
Where partnership agreements or LLC Agreements include provisions that specify the circumstances in which Notices delivered in accordance with their terms are "deemed" to have been received by the equity holders, a Lender might take some comfort in proof of delivery of the Notices in accordance with the provisions of such partnership agreement or LLC Agreement, rather than proof of receipt by way of a signed acknowledgment by the equity holders. In all cases, the recommendation would be that the general partner, or an authorised person on behalf of the Cayman LLC, sign and deliver the Notices to the equity holders in accordance with the provisions of the limited partnership agreement or the LLC Agreement governing service of Notices on the equity holders, with a copy delivered to the Lender.
Apart from establishing priority, delivery of a Notice to equity holders of an assignment of Capital Call Rights has other distinct advantages, three of which are discussed below.
Firstly, it prevents equity holders from obtaining good discharge for their obligations to fund their Uncalled Capital in any manner other than as specifically indicated in the Notice. Once Notice of the assignment has been delivered to each equity holder, indicating that equity holders are to make all payments with respect to Uncalled Capital into a designated Lender controlled account, the equity holders will not be in a position to discharge their obligations to make such payments in any other manner.
It also prevents set-offs from arising after the date of service of such Notice. This rationale is based on the common law principle that set-off works between the same parties in the same right. If there is Notice to one party of the assignment of a right to a third party (i.e. a Lender), set-off will no longer operate in the same manner. However, the service of Notice on equity holders does not have the same effect with respect to claims that might have arisen prior to the date of service of the Notice. Most limited partnership agreements, LLC Agreements and/or the accompanying subscription documents will now incorporate express waivers on the part of equity holders confirming that they will not rely on any right of set-off in order to reduce their obligations to fund their Uncalled Capital. Usefully, these contractual waivers survive the insolvency of the ELP, as the insolvency provisions of the Cayman Islands Companies Law (which apply to ELPs by virtue of Section 36 of the Cayman Islands ELP Law and to Cayman LLCs by virtue of Section 36 of the LLC Law) expressly provide that the collection in and application of property on the insolvency of a company (or partnership, as the case maybe) is without prejudice to and after taking into account, and giving effect to, any contractual rights of set-off or netting of claims between the entity and any persons, and subject to any agreement between the entity and any persons to waive or limit the same.
This serves as an important informational tool insofar as equity holders are concerned. Once an equity holder has taken delivery of the Notice, it becomes more difficult for such holder to challenge the enforceability of a call made pursuant to the facility in question based on a lack of knowledge or awareness of the existence of the same. Although there is no public registry relating to the grant of such security in Cayman, there is a statutory requirement for Cayman Islands exempted companies and Cayman LLCs to enter particulars of all mortgages and charges created over their assets (wherever located) in a register of mortgages and charges maintained at their registered office. Importantly, the statute does not aim to impose perfection requirements, and failure to enter such particulars will not invalidate the security. However, exempted companies and Cayman LLCs are expected to comply with the requirement, and failure to do so will expose such companies to a statutory penalty.
While there is no corresponding requirement for a Cayman ELP to maintain a register of mortgages and charges with respect to charges over its assets, where the general partner of an ELP is incorporated as a Cayman Islands exempted company or a Cayman LLC and such general partner has granted security in its own right, the general partner will be subject to the statutory requirement discussed above. In the context of a subscription cred it facility secured by an ELP's Capital Call Rights, given that legal title to the ELP's assets will be held by the general partner, details of security granted by the general partner in its own right and on behalf of the ELP should therefore be recorded in the register of mortgages and charges of the general partner. In practice, this puts any person inspecting such register on Notice as to the existence of the security.
COVID-19 and fund finance
The COVID-19 crisis has tested the resilience of the fund finance market during the course of the year. Yet, despite the challenges presented by COVID-19, there have been no advertised defaults on investor calls by institutional investors in any fund with a capital call facility.
The market has largely withstood the dislocation caused by the pandemic precisely because of the liquidity options that it has continued to offer general partners during this time. While the systemic financial crisis in 2008, which was squarely focused on the banking system, caused liquidity issues, fund finance has continued to offer liquidity solutions at a time when the epicentre of the crisis is located outside of the financial markets.
Many of the pressures associated with the pandemic have manifested in different ways with respect to various market participants. On the Lender side of spectrum, we noticed a shifting of activity levels earlier in the year, with some of the larger banks stepping back from origination and/or agency roles to focus on portfolio management, clearing a path for other banks to fill the supply gap. This may shift again as banks that were active earlier in the year meet up on allocation limits in Q4. We also saw a steady stream of amendments, extensions, joinders and upsizes – testament to solid historical relationships between general partners and Lenders. All in all, the market has, to date, remained fairly robust. It remains to be seen; however, how the macro-economic environment will impact Q4, particularly insofar as fundraising is concerned.
Beneficial Ownership Regime
Cayman Islands companies and Cayman LLCs are required to maintain registers of beneficial ownership at their registered offices, pursuant to legislation that came into force on 1 July 20 17 (Beneficial Ownership Regime). As a result, barring any applicable exemptions, in-scope companies must take "reasonable steps" to identify individuals qualifying as "beneficial owners" or corporate vehicles qualifying as "relevant legal entities". Beneficial owners are defined as those individuals who hold: (i) directly or indirectly, more than 25% of the shares, Cayman LLC interests or voting rights in the company; or (ii) the right to appoint or remove a majority of the board of directors or managers of the company. If no individual meets these conditions, the Beneficial Ownership Regime looks to those persons who directly or indirectly exercise significant influence or control over the company through direct or indirect ownership or interests. Generally, "relevant legal entities" are intermediate holding companies registered in the Cayman Islands through which beneficial owners hold their registrable interests.
Subsequent amendments to the Beneficial Ownership Regime, among other things, add exemptions for companies that are (or are subsidiaries of one or more legal entities that are): (a) regulated in an anti-money laundering-equivalent jurisdiction; (b) the general partner of a special purpose vehicle, private equity fund, collective investment scheme or investment fund that is registered or holds a license under a regulatory law; or (c) holding, directly, a legal or beneficial interest in the shares of an entity licensed under the Banks and Trust Companies Law, the Companies Management Law, the Insurance Law, the Mutual Funds Law, or the Securities Investment Business Law. A further key amendment is that any company that claims an exemption from the Beneficial Owner ship Regime must provide its corporate service provider with written confirmation of the exemption.
The Beneficial Ownership Regime extends the Cayman Islands' commitment to help combat tax evasion, terrorist financing, money laundering and other serious and organised crimes, by providing greater transparency on beneficial owners.
The potential significance of the Beneficial Ownership Regime for Lenders in a fund financing transaction lies in the remedy available to a company in the case of non-compliance by an equity holder with a request for beneficial ownership information. If a company does not receive such information within one month of requesting it, it may issue a "restrictions notice" in respect of the relevant interest held by the equity holder. Until such notice is withdrawn by the company or ceased by court order, any transfer or agreement to transfer the interest is void, no rights are exercisable in respect of the interest, no shares may be issued or additional rights granted in respect of the interest or in pursuance of an offer made to the interest holder, and no payment may be made from the company in respect of the interest, whether in respect of capital or otherwise. Further, other than in a liquidation, an agreement to transfer a right to be issued any shares in respect of the relevant interest or a right to receive payment in respect of the interest will be void.
Given that: (i) the Beneficial Ownership Regime currently applies only to companies and to Cayman LLCs (and not to ELPs) and only where an exemption from the Beneficial Ownership Regime is not applicable; (ii) regulated investment funds and funds (including private equity funds) having a manager or administrator who is regulated in Cayman or in a jurisdiction approved by the Cayman Islands' Anti-Money Laundering Steering Group remain outside the scope of the Beneficial Ownership Regime; and (iii) a restrictions notice may not be served in respect of an interest that is subject to the security interest of an arm's length security holder, the enforceability of an unaffiliated Lender's security package in subscription financing transactions should remain relatively unaffected by the Beneficial Ownership Regime.
The Cayman Is lands introduced the International Tax Co-Operation (Economic Substance) Law, 2018 (ES Law) in January 2019. The ES Law requires certain entities incorporated or registered in the Cayman Islands, and carrying on "relevant activities", to have "adequate substance" in the Cayman Islands. The ES Law applies to "relevant entities" that conduct any "relevant activity". Such entities must establish "adequate substance" in the Cayman Islands, and will be subject to administrative penalties and, ultimately, strike-off for failure to comply.
Relevant entities include: (i) Cayman companies (including exempted companies and LLCs); (ii) limited liability partnerships; and (iii) non-Cayman companies that are registered in Cayman (which would include a foreign company that acts as a general partner of a Cayman ELP), but exclude (x) investment funds, and (y) entities that are tax-resident outside of the Cayman Islands. ELPs are currently out of scope. While all "relevant entities" are required to declare their ES Law status in their annual filing, only those entities that are carrying on "relevant activities" are required to comply with economic substance requirements.
There are nine relevant activities under the ES Law, the most relevant for these purposes being "holding company business" and "fund management business".
Cayman corporate blocker entities or corporate vehicles that are not classified as investment funds and not otherwise tax-resident outside of the Cayman Islands will be subject to the ES Law. A corporate vehicle carrying on "holding company business", which is defined as "pure equity holding business" – i.e. only holding equity participations in other entities and only earning dividends and capital gains – is in scope, but is subject to a reduced economic substance test. In practice, this should be met by its ongoing compliance with existing statutory obligations. Compliance by other corporate vehicles should, however, be initially assessed by Lenders' counsel, and all corporate vehicles should be monitored on an ongoing basis for continued compliance with the ES Law.
A foreign corporate general partner registered in the Cayman Islands would be considered a "relevant entity" but would not likely be carrying out a "relevant activity" such as "fund management business" (except in unusual situations). As such, while it would need to declare its status in its annual filing, it would not be required to actually comply with economic substance requirements.
The Cayman Islands Private Funds Law, 2020
The Private Funds Law, 2020, as amended (PF Law), came into force on 7 February 2020 and has created an entirely new regulatory regime for private investment funds. The PF Law applies to any "private fund" carrying on business in or from the Cayman Islands other than a mutual fund or an EU connected fund regulated under the Mutual Funds Law.
The PF Law defines a "private fund" as a company, unit trust or partnership that offers or issues or has issued investment interests, the purpose or effect of which is the pooling of investor funds with the aim of enabling investors to receive profits or gains from such entity's acquisition, holding, management or disposal of investments, where:
- the holders of investment interests do not have day-to-day control over the acquisition, holding, management or disposal of the investments; and
- the investments are managed as a whole, by or on behalf of the operator of the private fund, directly or indirectly,
but a "private fund" does not include:
- a person licensed under the Banks and Trust Companies Law (2020 Revision) or the Insurance Law 2010 (which can be searched on the CIMA online database https://www. cima.ky/search-entities);
- a person registered under the Building Societies Law (2020 Revision) or the Friendly Societies Law ( 1998 Revision); or
- Any non-fund arrangements.
Single investor funds are out of scope and are therefore not required to register. Non-fund arrangements such as joint ventures, pension funds, holding vehicles and securitisation special purpose vehicles are expressly excluded from the ambit of the regime. However, Cayman Islands alternative investment vehicles, single investment funds, some master funds, and some funds whose interests are not being "offered", may be in scope as a result of the July 2020 amendments to the PF Law.
All private funds must apply to be registered with the Cayman Islands Monetary Authority (CIMA) within 21 days after accepting capital commitments from investors. Failure to register within such time exposes the fund to an administrative penalty. Significantly for fund finance transactions, an in-scope fund must be registered by CIMA before it accepts capital contributions for investments. After a summer of some jostling and jockeying between Lenders and borrowers, as the potential impact of a fund's failure to register by the end of the transitional period was considered, credit documentation will now typically incorporate registration commercial papers to closing and/or joining and covenants to maintain such registration under the PF Law.
The year ahead
Despite macro-economic uncertainties in the global markets, the forecast for private equity fundraising over the next few years remains optimistic, and given the ability of top US based sponsors to raise money from institutional investors based in the US, we anticipate that the North American market will continue to dominate. Cayman will remain relevant for North American and Asia-focused funds, in particular. As the industry matures the demand for fund finance solutions throughout the lifespan of the fund will likely increase, as will the need for its underlying portfolio companies to be supported. This demand will be satisfied by an increasing number of sophisticated Lenders willing to offer attractive and diverse financing options – which include not only subscription facilities, but the more bespoke NAV facilities and management fee facilities.
The strength of this market is that it has thrived on strong collaborative relationships between Lenders and fund sponsors alike. We suspect that evolution and innovation will always be a feature of the industry. The market will continue to evolve and is poised for continued growth in 2021 and beyond.
For the original chapter in GLI – Fund Finance 2021 please visit: https://www.globallegalinsights.com/practice-areas/fund-finance-laws-and-regulations/cayman-islands
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.